Hi, Else here.
And in this video, we'll start exploring financial statements,
what they look like, and how they're interconnected.
Why are financial statements necessary?
Remember that external stakeholders, mainly investors,
lenders, and other creditors, have
to make decisions about resource allocations--
where to put their money.
They use financial statements to answer questions
that they may have about a business, income statement,
statement if retained earnings, balance
sheet, and the statement of cash flows.
Statements must be completed in a specific order
and we'll start with the income statement.
An income statement reports the results
of a business day-to-day operations, the revenues
less the expenses incurred to generate that revenue
to obtain a profit figure, called net income.
The income statement measures the businesses performance
within a period of time, either annually, quarterly,
or monthly.
To better understand the income statement,
we have to understand the two main elements-- revenues
and expenses.
Revenues are the income that a business earns.
There are only two ways to earn revenue.
Businesses either provide a service or a good.
The key to revenue is that it must be earned.
What does that mean?
It means that the business has done their job--
past tense.
For example, if a lawn care business
plans to mow a customer's lawn tomorrow,
it has not earned revenue today, because they have not
done their job as yet.
After they finished mowing the customer's lawn,
they have earned their revenue.
If a retail store plans to sell a product to a customer
tomorrow, revenue is not earned because again, the business has
not, as yet, done their job.
Revenues can only be recognized when the business has
finished the job, provided the service, or delivered the good.
Notice the past tense--
that's very important with regards to the element revenue.
To summarize, revenue is income earned
through the day-to-day activities of a business
when a service or good is provided.
Revenue-- earned by providing services or goods.
Expenses are the cost of the resources that
have been used, consumed, or incurred
to help generate revenue.
Expenses are best described through an example.
If you use gas in a lawnmower when you move a customer's
lawn, then the gas that was consumed
during the mowing of the lawn is an expense
of costs to earn the revenue.
Why?
Because the gas was consumed in order to help
generate service revenue.
Note that the concept of used, consumed, or incurred
is important, but so is the fact that these things must
have happened in order to earn revenue.
Costs or expenses must be matched to the revenue
they helped to generate.
Expenses-- cost of what is used, consumed, or incurred to help
generate revenue.
Now that you understand the elements
that make up the income statement,
let's look at the format.
The format of an income statement is important.
Note that the heading must always
include the company name, the title
of the financial statement, and the time period covered.
Then revenues are listed first.
If there are multiple revenues, you
must list each different type of revenue
individually, and then show a subtotal called total revenues.
Is there a correct order for revenues?
Generally, they're placed in the order of magnitude-- meaning
from the highest amount to the lowest.
Why?
Because, remember the purpose of financial reporting--
provide information for external uses
to make resource allocation decisions.
Therefore, highlighting the larger sources of revenue
first help to make the information more understandable
and increases clarity.
Expenses are listed next with the heading called
operating expenses.
The order of expenses, similar to revenues,
are from the largest to the smallest.
After listing all the expenses, the statement
provides a total of all the expenses,
excluding income tax expense.
Next is the subtotal-- income before income tax expense
calculated as total revenue minus total expenses.
Then, income tax expense as a separate expense
item before listing a final net income amount.
Often, textbooks show income tax expense in the same listing
as operating expenses.
However, this is incorrect.
Operating expenses are the cost of operating the business
and are controllable, for the most part, by the business.
Income tax expenses prescribed by the CRA--
Canada Revenue Agency-- and is not at all controllable.
As a consequence, income tax expense
must be listed separately.
What happens if expenses are greater than revenues?
Then a net loss amount is provided at the bottom
of the income statement.
The statement we have developed here
is called the single step income statement.
We'll be covering a multiple step income
statement in a future video.
Remember to pause the video to determine your answer to this
Check your understanding question about the uses
of the income statement.
Investors are interested in a business has passed performance
because it helps them.
The answer is not A--
determining the amount of debt a business currently
has is answered by reviewing the balance sheet.
The answer is not B either, as the current value
of a business's property, plant, and equipment
is not available on any financial statement that
is produced under ASPE.
The answer is not D either-- determining
if a business is profitable enough
to repay its debt is what lenders and creditors will
use the income statement for, not investors.
The correct answer is C, as investors
are interested in determining the future profitability
of the business.
Why is this?
Because it will help investors determine
if they will get the return on their investment
that they want in the future.
Lenders use the income statement to help them determine
if they want to fund a business with loans
and if the business will be in a position to repay the loan
plus interest in the future.
Other creditors use this statement
to figure out if the business will be profitable enough
to repay their debts as they come due.
The long-term survival of any business
depends on its ability to produce revenues that are
greater than their expenses.
Profit allows a business to fund their financing activities
by paying dividends to shareholders and interest
to lenders.
It also allows the business to pay for investing activities,
like buying new equipment.
Income statements, which show past performance,
gives stakeholders information to help them make predictions
about future profitability.
Since the net income from the income statement
is used in other statements, its always the first financial
statement completed.
The next statement produced is the statement
of retained earnings.
We'll be covering that statement in our next video.